How many stocks should you have in your portfolio?

How many stocks should you have in your portfolio?

Today we are going to keep this post as simple as possible and focus on three key elements that we consider important (but by no means exhaustive) when identifying investments and managing a portfolio. For simplicity we have broken down these categories into quality, quantity and return considerations which we hope may add some value to your investing endeavours.

Quality often means different things to different investors. For example it could refer to a business’s balance sheet, its prospects, or its assets. For us however, quality refers to a company’s ability to earn high returns on invested capital for a sustained period of time.

At Montgomery we’d much rather own a handful of businesses that can reinvest meaningful amounts of capital back into the business at 20 per cent per annum, than 100 hundred business generating 5 per cent and paying almost all of its earnings out as a dividend. Something we touched on recently here.

We believe that if you can identify a business that has an extended competitive advantage period and is able to generate high returns on every dollar it reinvests, it’s highly likely that you have an investment asset that will; 1) Have attractive growth prospects over the medium term and, 2) Will perform solidly over the long term. It is for these reasons that you should seek to build a portfolio filled with these types of businesses, purchased and owned at attractive prices.

Quantity. Again, this will differ depending on who you ask, but just how many businesses should you aim to hold in your portfolio?

It’s a well-known fact in academic research that the majority of benefits from diversification (spreading risk) accrue in a portfolio comprised of just 10 businesses with risk reduced to an even lower acceptable level when a portfolio reaches 20 positions.

In “Risk Reduction and Portfolio Diversification: An Analytical Solution” (Journal of Business, written way back in 1977), Edwin Elton and Martin Gruber found that the benefits of diversification are negligible once a portfolio increases in size beyond 20 different investments. To demonstrate this graphically, the chart below plots portfolio standard deviation (the academics measure of risk) against the number of holdings.

Source: Cautious Bull

In our view this makes logical sense. In practice, one only needs to consider the basics of investing and ask the question; are you adding value by putting money into your 30^th ‘best idea’? We believe the answer to that question is relatively straightforward, preferring to add more to our highest conviction ideas and concentrating rather than diversifying broadly.

So when it comes to building your own portfolio, think about how you could be backing your best ideas more meaningfully rather than adding more and more hopefuls which will only see you building a library of investments. We’ve seen many such examples of just this over the years, portfolios which come with the frustration of failing to deliver the outcomes desired in terms of returns.

And finally, when considering returns, whilst many investors I regularly speak to are constantly trying to pick the next winner, we believe that avoiding the losers and making dumb mistakes in the share market is just as important.

There’s a simple mathematic equation that’s worth considering before ever buying a share on the stock market: if you lose 50 per cent of your capital, you have to then generate 100 per cent back just to break even. Burn this one into your brain.

If you have $10,000 invested in a company and you buy it on nothing more than a tip and it halves in price, which constitutes a paper loss of $5,000 or 50 per cent in the red. From that position the share price either has to double just for you to get back to where you started or your next tip better be a good one!

It’s a situation which can put you at a significant disadvantage even if you only have one poor performer in your portfolio, which is why as part of the research we undertake and indeed well before we ever push the buy button, instead of asking how much we can make, first we ask how much can we lose.

If we are considering an investment that can make us a little but has significant downside risk, then the investment idea probably doesn’t stack up and the risk to reward ratio is just not in our favour.

Rather, we attempt to fill our portfolio where this situation is reversed. That is, where in our view the downside is limited, but we have reason to believe there is materially more to the upside.

In that way you tilt the risk to reward ratio in your favour and hopefully, the returns.

Russell Muldoon is the Portfolio Manager of The Montgomery [Private] Fund. To invest with Montgomery, find out more.